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The following was written by Bruce Roberts, Founder and CEO of Carofin.
Private investing can be rewarding…but it’s always challenging. There are so many offerings to choose from, but each one is very different from the other. Investors need to apply an analytical approach to each private investment that is consistent and effective, while also efficient.
You can’t digest all the various details of a given opportunity at once, but you can organize your review by focusing on the key factors that determine whether a given investment is right for you – or otherwise merits further analysis.
Consider this a “first pass” framework to help you quickly obtain a fundamental understanding of a private security offering. It does this by prioritizing five areas of influence on the investment’s structure and eventual outcome – what we are calling the “Five Elements” (the “Elements”).
The Elements, once understood, establish a platform for more in-depth research – a full “due diligence” investigation. Investment analysis involves a journey where a relatively obscure, under-weighted detail can ultimately derail the investment’s performance.
But getting too granular too quickly in the evaluation process can also lead to a missing of the “forest for the trees.” This is about making sure an investor first achieves an adequate understanding of the forest.
The order followed during the investor’s analysis is also important. With Elements, an understanding of the private offering builds, step-by-step, as each Element is addressed.
Since each of the Five Elements interrelates, reviewing these topics in order enables the investor to gain an appreciation for how each pertains to the totality of the investment as an understanding of the investment unfolds.
Sequence for evaluating a private investment
The analysis should follow this simple sequence:
1. Purpose – Why is this capital being raised?
2. Issuer – Who is issuing the security?
3. Security – What type of investment is being offered?
4. Repayment – What determines the success of the investment?
5. Risks – What can go wrong?
Purpose of a financing
Understanding a financing’s purpose – the “why” of a securities offering – provides the underlying context for each of the other Elements while also helping to reconcile whether what’s being presented to the investor makes sense.
An early understanding of the purpose of the underlying financing often enables investors to immediately determine whether they wish to keep exploring the investment opportunity. For example, does the investor want to be associated with the underlying business of the Issuer such as cannabis or alcohol production?
Identifying what the cash proceeds from the offering are to be used for also paints a clear picture of the offering’s purpose. Is it for short-term working capital needs or for longer-term business development? Are the funds supporting organic growth or to make an acquisition? Will the proceeds build the business or be used to make distributions to existing investors?
- How will the offering proceeds (the cash raised) be used?
- What will be accomplished with this capital?
- How does this financing and related activities further the Issuer’s mission?
- Why raise the capital now?
- What kind of security structure does the purpose suggest is most appropriate (e.g., debt or equity, long-term or short-term investment)?
[Related: What is a “direct private investment?“]
Importance of the issuer
The party carrying the financial obligations of the security is called the issuer. It’s vitally important to assess the basic nature of the issuer, its owners, and senior management since, collectively, they will have the greatest impact on the security’s performance. If you don’t understand who the issuer is, you’re not making an investment. You’re gambling…
- Senior management – Who is leading the company and what are their qualifications and limitations?
- Ownership – Who are the existing shareholders, how is ownership held, is it concentrated and what are their motivations?
- Stage of business – Venture (pre-operating cash flow) or more established (positive EBITDA, profitable). Without positive cash flow, it’s impossible to service debt without selling assets or raising new capital. The stage of the business should be reflected in the investors’ potential return on investment (ROI).
- Industry – Each industry necessitates vastly different operational considerations, capitalization and investment risks.
- Form of incorporation – Is the issuer a taxable entity (C corporation) or a pass-through for tax purposes (such as a Limited Liability Company or an S corporation).
- Operating company or Single Purpose Vehicle (SPV) – Is the issuer an operating company with a business plan, dedicated employees, and fixed operating expenses, or is it an SPV that has been created to enable a financing structure benefiting other third-parties (which isn’t necessarily a bad thing)?
- Structure of company – Is the investment in a holding company or at the operating company level where tangible assets, direct customer relationships, and specific revenue-generating business activities are carried out?